Mutual Fund To No Longer Invest In 'Too Big To Fail' Banks

A top-ranked mutual fund will no longer invest in "Too Big To Fail" banks, announcing Thursday it would extend a prohibition already in place against tobacco firms and pornography distributors to banks like Citigroup and Goldman Sachs Group.

In its release Appleseed Fund, a self-described socially-responsible fund that was created in 2006, said that Too Big To Fail (TBTF) banks are also "too big to own." The TBTF firms are now treated by the fund like those that "derive substantial revenues from the tobacco, alcohol, pornography, gambling, or weapons industries," according to the fund's filings.

It is the first mutual fund to explicitly state that it will not invest in TBTF banks, the $140 million fund said in its announcement.

"The cost of bailing out Wall Street since 2008 is over $3 trillion, or more than $20,000 per taxpayer, and that cost is increasing daily," Adam Strauss, one of the fund's co-portfolio managers, said in a statement. "The financial burden of that bailout will be felt for a generation and will be paid by children, some not yet born. Instead of an industry structure where the largest banks are serving the economy by lending capital, U.S. policies and regulations favor the largest banks, which have proven themselves incapable of fiscal rectitude.

"Given the failure of regulators to prevent the previous credit crisis and the subsequent failure of legislators to break up the massive and very much interconnected banks that helped to create the crisis, it is incumbent on depositors and investors to vote with their wallets. Until the financial system is truly restructured, the Appleseed Fund will avoid investments in Too-Big-To-Fail banks, choosing instead to invest in regional banks, community banks, and credit unions which lend money to families and businesses that operate in the productive sectors of our economy," he added.

Though the fund does not own any shares in any of the five banks it identifies as Too Big To Fail, its official policy will go into effect on Jul 1. The fund invests in undervalued stocks for the long-term, making it a "value fund" that employs a similar investment strategy as famed investor Warren Buffett. According to Morningstar, a widely-watched mutual fund data provider, the fund is the top performing midcap value fund over the past three years, generating a 3.5 percent annualized return for its investors. The second-ranked fund generated a 0.4 percent return. The Standard & Poor's 500 Index returned a negative 9.8 percent over the same period.

"The banking system's current industry incentives are misaligned since employees keep a disproportionate amount of the profits while taxpayers subsidize the losses; this unhealthy imbalance is unsustainable and encourages excessive financial speculation," Strauss said.

"In the financial reform bill which recently passed the House of Representatives [and will likely soon pass the Senate], Congress failed to break up or limit the size and scope of the largest banks that have destabilized the financial system and destroyed so much value over the past five years. We were disappointed lawmakers did not stand up to the banking lobby in order to avoid future bailouts. Without meaningful reform, we fear the next crisis will be larger and more devastating than the last," he added.

Strauss said his fund has deemed five banks Too Big To Fail because they each hold derivatives contracts totaling at least $10 trillion in notional value. JPMorgan Chase, Bank of America, Goldman Sachs, Citigroup and Morgan Stanley, which dominate the derivatives market, are the only U.S. banks that fit this criteria. The next closest bank, Wells Fargo, holds $3.7 trillion.

Those five banks join the likes of Altria Group (parent company of Philip Morris USA), Anheuser-Busch InBev NV (the world's largest beer brewer and maker of Budweiser), and Lockheed Martin (one of the world's biggest weapons manufacturers) on the list of firms the fund refuses to invest in.

Strauss said the fund hasn't invested in TBTF banks since the end of 2007. It had owned shares of Citigroup, which comprised about four percent of the fund's portfolio. Citi, in fact, was one of the fund's top holdings.

But after news reports about the bank's structured investment vehicles began to surface, Strauss and his team dumped their shares. Known as SIVs, the off-balance-sheet entities enabled banks to offload hundreds of billions of dollars in loans and securities, freeing up the banks to loan out even more money. Citi's were particularly toxic, forcing the bank to bring them onto the firm's balance sheet and absorb tens of billions in losses. The full extent of Citi's SIVs had not been previously disclosed until the fall of 2007.

"When that happened, we basically stopped everything in our office and spent a week looking at Citigroup, trying to understand what was going on and really how much exposure they had," Strauss said.

They eventually dumped their Citi position at around $45 a share. It closed Thursday at $3.97.

"When we sold Citigroup we determined that it wasn't just Citigroup but it was a lot of banks that were involved with these SIVs and in the whole securitization market that were going to have capital problems and were going to have to raise capital," Strauss said. "We've stayed out since then."

However, it was the recent bonus binge at TBTF banks that solidified the fund's thinking.

"What's been remarkable to us has been the compensation that's been paid out over this last year, even while if you marked their assets to market most of these banks would be insolvent," Strauss said. "For these banks to be as unhealthy as they are, for them to be paying out the kind of compensation that they're paying, seems to us to be irresponsible. And, at the same time, there are risks they're taking with their balance sheet, and if those risks go wrong the American public is on the hook for them."

He continued:

"In retrospect, it seems clear that much of went on during the whole housing-bubble, credit-bubble era was that regulators were captured by the banks. It seems to us now that Congress is captured by the banks, which is why the bill being discussed right now doesn't include any concept of breaking up the banks or reducing them down to size.

"As a fund, we don't think [Too Big To Fail banks are] responsible, we don't think we're going to make a lot of money on them," Strauss added. "We'd rather invest in other kinds of banks."

The Appleseed Fund is managed by Pekin Singer Strauss, a 20-year-old Chicago-based investment firm. The fund's investors have received an annualized return of 5.7 percent since inception.

Echoing the view held by many former federal regulators, current regional Federal Reserve Bank presidents, top economists and leading market participants, Strauss said that Congress had a chance to enact meaningful reform when it came to ending Too Big To Fail, but failed. That's another reason why the fund enacted its recent policy.

"It seems to us that true meaningful reform is not going to occur," said Strauss. "The reason that we're out is that we don't feel comfortable that the reforms that are being implemented are going to protect depositors or investors or taxpayers. And so we just want to stay as far away as possible for investment reasons."

He added that the dearth of criminal prosecutions that should have arisen from what some have said was a fraud-induced bubble also convinced him that policymakers weren't serious about tackling Too Big To Fail.

"Think about during the last bear market all of the people who were indicted or went to jail related to fraud," Strauss said. "You had Enron, you had WorldCom -- we went after those executives.

"Where are the criminal prosecutions in this particular scenario? Where are the true reforms to make sure this doesn't occur again? We just don't see it. We appreciate that there's going to be a lot more regulation in place, but we don't feel confident that the regulators are going to avoid being captured by the Too Big To Fail banks this time any more than they were last time."

Strauss added that the fund's thinking on the pending financial reform bill, now called Dodd-Frank after its leading Democratic sponsors, Senator Christopher Dodd of Connecticut and Representative Barney Frank of Massachusetts, is consistent with Sen. Russ Feingold's views. In a June 30 statement the Wisconsin progressive said the bill "caves to Wall Street interests [and] it doesn't meet the test of preventing another financial crisis." He opposes the bill.

"As long as there are banks that are Too Big To Fail then the banking system hasn't been reformed enough," Strauss said.

Told that the Obama administration has repeatedly said that the Dodd-Frank bill ends Too Big To Fail, Strauss replied: "Honestly, we're skeptical of a lot of the things we hear."